Following the today's FOMC rate decisions, we could forgive a certain big lizard for mistaking the U.S. for Japan. After all, the yields found among our U.S. treasuries look remarkably similar to those found in Japan in the 1990s. Truthfully, yields were lower in 1990s Japan, but you get my drift.
The FOMC's rate decision surprised many Wall Street forecasters. The Street had been divided into two camps, one forecasting a 50 basis point rate cut and another forecasting a 75 basis point rate cut. The Fed did one better by setting the Fed Funds rate to a range of 0.00% to 0.25%. A range you say? This was common decades ago and permits lending within a range depending on conditions. Essentially, the Fed lowered the Fed Funds rate to zero without officially doing so.
The Fed's statement pulled no punches. Mr. Bernanke and Co laid it all on the line. Here is a copy of the FOMC statement:
The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent.
Since the Committee’s last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further.
Meanwhile, inflationary pressures have diminished appreciably. In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters.
The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.
The focus of the Committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Christine M. Cumming; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.
In a related action, the Board of Governors unanimously approved a 75-basis-point decrease in the discount rate to 1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Cleveland, Richmond, Atlanta, Minneapolis, and San Francisco. The Board also established interest rates on required and excess reserve balances of 1/4 percent.
The Fed acknowledged that weak economic conditions will persist for some time and that it will employ all means at its disposal. Since the Fed has fired all of the arrows in its Fed Funds quiver, what ammunition remains? The Fed can continue to purchase GSE bonds and GSE mortgage-backed securities to lower lending rates. It can also purchase long-dated treasuries to lower mortgage benchmarks. I think this ammunition will in fact be fired. This will keep long-term treasury yields artificially low considering the increased amount of government debt issuance and an increase to the money supply. Although long-term treasury yields fell (as expected) on today's FOMC statement, the U.S. dollar fell versus the euro and the yen. Eventually, the increased printing of money will be inflationary (actually the Fed's goal) that, combined with increased debt issuance, should eventually push long-term yields significantly higher, but probably not until 2010.
How much will long-term rates rise? This is he $20 million question. From a fundamental standpoint, a 6.00% or 7.00% (or higher) 10-year treasury note is not out of the realm of possibility. However, our "trading partners" have vested interests in keeping long-term treasury yields low to keep U.S. consumers borrowing and spending (once economic conditions recover).
The government's overall weaponry is not limited to Fed securities purchases. The Treasury and the Fed will keep banks well-capitalized. Expect more issuance of FDIC insured TLGP bonds. It is imperative that banks remain well-capitalized. Large banks will not be permitted to fail. This means that they will not be permitted to default on bond payments, at least not in the near term.
How and why will government not let large banks default on bond payments? The "why" is easy. Default on any bond payments, and one defaults on all bond payments. This makes banks wards of the FDIC and puts the government on the hook for the payment of billions of dollars of TLGP bonds. The government will not permit this to happen, at least not during the TLGP period which extends out until June 30, 2012.
How will the government keep banks solvent. It will keep the discount window and other "temporary" liquidity programs open. This however would add to banks' Tier-2 capital. If a bank's Tier-2 capital rises to over 100% of its Tier-1 capital, that bank is in violation of the Basel II banking agreements and is considered to be an unstable institution. Other banks will cease doing business with the troubled bank.
The government could purchase more preferred stock shares from banks, but this may only be done in extreme circumstances. What the government could do is order a troubled bank to suspend all common and preferred equity (non-cumulative preferred) dividends payments to conserve cash to make bond interest payments. Not paying preferred dividends would save substantial sums of cash and would not put a bank in regulatory jeopardy. As the government's preferreds rank equal to outstanding non-cumulative preferred stock, it is very easy for the government to order a suspension of these dividends and those of common stock. It may be better for the government to forgo its own dividend payments rather than add more capital. One look at the yield differential between cumulative and non-cumulative preferreds of some issuers tells us that the market is also concerned. Investors may want to consider trust preferreds which are senior to the government and non-cumulative preferreds as they are a kind of junior subordinate debt.
Another opportunity maybe non-FDIC bonds issued by large TLGP-participating banks out to June 2012. These banks will be well-capitalized during that time and significant yield pickups can be had.
I want to apologize for not writing much this past week. I did have some computer issues. I will be on vacation for much of the time between December 19th and January 5th.
Happy Holidays to All
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